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Share market valuation – is it cheap or expensive?
Using the Price to Earnings Ratio (P/E) to Understand a Company’s Share’s Value
A popular option for evaluating a company’s share price is the price to earnings (P/E) ratio. The P/E ratio provides an indicator of how much investors will pay for each unit of earnings.
Companies use this metric to gauge if their share price is lower or higher than it’s been in the past. It can also be used to compare the value of shares between companies.
To find the P/E ratio, divide the current share price by the current earnings per share. If a share has a P/E ratio of 20, then, investors are willing to pay $20 for each dollar of profitability.
A good rule of thumb for many investors is to look for a P/E ratio of 20 or less. But beware of a value trap. This is when a share seems cheap due to low P/E, but that low P/E implies dim future earnings prospects. Companies like this may not be a sound investment.
So, is the market cheap or expensive?
Global share markets have rallied strongly since around November last year. While we still believe growth assets will provide a risk adjusted premium to cash and bonds over the medium term, at the moment the market, based on a Price to Earnings (PE) ratio, looks EXPENSIVE.
The Australian market average is around 14 times and as per the chart below it is currently trading at close to 20 times. When this occurs we generally hold more cash and wait for valuations to improve or a trigger event, like the US election later this year.
August Reporting Season
Companies listed on the Australian stock exchange report their earnings twice a year, in February and August. Hence this month is particularly important to see if the Earnings part of the P/E ratio justifies current share prices. For more information on Reporting season click here for CommSec’s coverage.
The Australian Share Market P/E Ratio
The US Share Market P/E Ratio
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